I believe that the operation of an economy is a good model for the operation of an academic discipline like economics. A well-functioning economy is one where there is healthy competition, we trade with other economies, and pursue innovations that improve the performance of the economy and create wealth. In the same way, a well-functioning discipline should also have healthy competition, trade with other disciplines and pursue innovations that improve the performance of the discipline and create knowledge.

Is this what we find in the economics discipline? Up to a point, yes. There is some competition, trade and innovation in the discipline, but I would say that it is much more limited than what we would find in a healthy economy.

This short piece focuses on innovation. The first important lesson we learn from studying innovation in the economy is that there is an essential distinction between incremental innovation and radical innovation. The use of the adjective incremental need not mean that the innovations are small. It means that they involve successive improvements in achieving a specific objective, where each innovation builds on all that has gone before. And the use of the adjective radical need not mean that the innovations involve ‘rocket science’, nor that they are controversial, but it does mean that they involve going back to the ‘roots’, and doing some things in a different way. If the process of innovation is to fulfil its full economic potential we need both types of innovation. Neither is sufficient without the other.

The second important lesson is that incremental and radical innovations tend to emerge from rather different environments. The best environment for incremental innovation is one in which there is an enduring division of labour. This is often an organisation with a reasonably stable organisational structure, where job descriptions and work routines are narrowly defined and stable over time. Staff build up a detailed knowledge of their part of the production process over a long period, and so they are exceptionally well qualified to point out ways in which it could be improved. Moreover, in such an organisation, staff in one specialised division often have little or no horizontal communication with other divisions, for the simple reason that it would serve no purpose. In such an environment, staff are encouraged to think inside the box.

In contrast, the best environment for radical innovation is one where staff are encouraged to bring together disparate and dissimilar knowledge. This is an organisation that wants some employees, at least, to think ‘outside the box’, because thinking outside the box is the best route to radical innovation. One type that is often discussed in this context, is the relatively young company, that has not yet developed a rigid organisational structure, where job descriptions are not ‘set in stone’, and where work routines are not stable over time. In such a ‘melting pot’, variability in working patterns means that workers are constantly being assigned to different groups, where they interact with people of different experience. In such an environment, staff are encouraged to think outside the box, and they are empowered to do so because they have accumulated considerable experience of problem-solving in teams with people of different experience and with diverse knowledge bases.

Mainstream economics is good at incremental innovation because it resembles the first type of organisation described above. But it is bad at radical innovation because it does not remotely resemble the second type of organisation described above. Indeed, mainstream economics clearly feels uncomfortable with most radical innovation.

In an innovative sector of the economy, it is commonplace to find an industrial structure that includes both types of organisations. There are the well-established and large incumbent firms who offer mainstream products and services, and incremental innovations. There is also a fringe of newer and innovative firms who aim to improve on some of the offerings from the mainstream, and offer something radically different. This is entirely healthy. In the same way, I think it is entirely healthy to create a similar ‘industrial structure’ in the economics discipline, and a similar fringe where radical innovations can flourish. That is radical, in the sense that it means going back to the roots and doing some things in a different way, but I don’t think it is controversial.

How do we create such an industrial structure? We should follow the example of many other disciplines, and change the constitution of the economics discipline from the conservative unitary state that it is at present, into a federation of semi-autonomous sub-disciplines. The following disciplines have all gone down that route: medicine, physics, chemistry, neuroscience, materials science, cognitive science, computing, geography, history, and business studies. Economics has sub-disciplines, certainly, but they enjoy little or no autonomy. Semi-autonomy is essential because radical innovation entails doing things that the mainstream may not approve of, but which are essential to solve the problems facing the discipline as a whole. These necessary innovations will only flourish in a federation where each sub-discipline has sufficient autonomy.

What new things will we find in the federation? If we are to give economics a proper empirical foundation, rather than rely on the black-box foundations built by econometrics, then we need to emulate the three essential empirical foundations of medical science: anatomy, physiology and pathology. Economic anatomy and economic pathology are still hopelessly under-developed. Economic physiology is quite well developed, but it is a black-box science, and does not draw on a deep understanding of economic anatomy.

There will also be a variety of hybrid disciplines in this economic federation – just as there are in medicine. These will include hybrid disciplines formed from several academic discipline – for example, in my own field of innovation. There will also be hybrid disciplines formed by academic economists working together with a wide variety of practitioners. These hybrid disciplines can play an essential part in addressing many sources of discontent amongst those outside the economics discipline.

This is how the economy creates the necessary mix of incremental and radical innovations.

I believe that it would be a very good idea if the economics discipline were to become more like the economy.

Giuseppe Eusepi and Richard E. Wagner give an analysis on Public Debt.

In the preface to his Guide to Aesthetics, the Italian liberal philosopher Benedetto Croce, in trying to define what art is all about, starts by stating what art is not. Following Croce’s example, Eusepi and Wagner explain what public debt is not within a democratic system of political economy. To define something by negation as a mode of investigation might lead one to believe that it is a pure exercise in rhetoric that can be dragged on indefinitely. This belief would be wrong. The definition by negation that Public Debt. An Illusion of Democratic Political Economy presents is necessary to explain the deeply misleading character of standard analyses on public debt.

Public Debt is not a work espousing the Ricardian equivalence between public debt and taxation. Nor is it a marginal critique of the Keynesian theory of fiscal policy. Public Debt explains the wrong-headed character of both Ricardian and Keynesian traditions within a democratic setting of political economy. While the concept of sovereign debt has a place within both Ricardian and Keynesian frameworks, it is oxymoronic when transplanted into a democratic setting where there is no room for a sovereign in the flesh with his own budget. When it comes to democracy, politicians can issue debt without being liable for its repayment, for they are simply intermediaries within the process of creating public debt. Contrary to the monarchical times of old, public debt is an illusion within democratic polities. To say this is not to deny that public debt exists, but is only to recognize that no identifiable agent is responsible for the creation or the extinction of public debt. Contrary to monarchical times, public debt in democracy imposes liabilities on one part of the population (taxpayers) while establishing benefits for another part (bondholders).

“Public debt has long been viewed as a primitive datum, as providing a starting point for analysis. To the contrary, public debt is a derivative outcome from a democratic budgetary process.”

Contrary to the conventional illusion about public debt, an entirely different view of public debt emerges from Antonio de Viti de Marco’s microeconomic approach. In his conceptual distinction between cooperative and monopolistic forms of democracy lies understanding as to why public debt in a democratic context is completely different from a pre-democratic one.

Public debt has long been viewed as a primitive datum, as providing a starting point for analysis. To the contrary, public debt is a derivative outcome from a democratic budgetary process. This point is important because the budgetary process may create public debt or may not; therefore, that process becomes crucial to explaining why public debt is created. If debt is a primitive datum, or an uncaused cause, as it is viewed by the standard macroeconomic approach, the only relevant aspect to be analyzed is the ratio of public debt to GDP.

What makes de Viti’s analysis interesting and relevant is his analytical distinction between a cooperative state, whose logic simply mimics market consensus, and a monopolistic state as a form of a real democracy, where consensus is replaced by the logic of majority and minority.

The insight that emerges from the standpoint of a monopolistic state is that public debt becomes a form of shell game. Similar to this gambling game, where the operator must convince the players of the legitimacy of the game using a sleight of hand, government operates a shifting of cost from dominant to subordinate groups as covered by an ideology of self-governance.

A further argument surrounding public debt is its ability to corrupt the language and practice of political economy. As an example of where a distorted vision of public debt can lead, it is instructive to consider a contract. Although a contract represents the purest concept in economic interaction, when that concept is extended to public ordering, leaving aside the hypothetical construction of a cooperative state, it becomes an expedient to obscure the role that public debt has in favoring politically dominant groups.

]]>https://elgar.blog/2017/07/18/public-debt-primitive-datum/feed/0CoinskatyroperPublic Debt, Political Economy, Finance, Money, Keynesian, RicardianBrexit Debate: Being Part of the European Global Macro-region Could be Vital for British Citieshttps://elgar.blog/2016/05/13/brexit-debate-being-part-of-the-european-global-macro-region-could-be-vital-for-british-cities/
https://elgar.blog/2016/05/13/brexit-debate-being-part-of-the-european-global-macro-region-could-be-vital-for-british-cities/#respondFri, 13 May 2016 14:52:39 +0000http://elgarblog.com/?p=5404

The two and a half year study* by Kathy Pain and Gilles Van Hamme withacademics in the UK, Belgium, France, Italy, Bulgaria and Sweden, identifies for the first time just how functionally interconnected and integrated the European economic space really is.

Despite improvements in information and communication technologies, declining transportation costs and increasingly transparent global markets, the results show that distance still matters and is a barrier to international trade.

While the UK is shown to be the least ‘European’ member state in terms of its regional relations, British and other European cities are interlocked by inter-urban business networks which add value to UK trade, and to trade across Europe as a whole. During the 2007/08 global financial crisis when international commercial office investments slumped worldwide, inward investment flows actually concentrated on London and other European cities in contrast to the picture for New York and the US.

In increasingly competitive global markets, international firms using European cities as their bases to do business, powerfully interlink them. Maintaining UK-Europe intense intercity flows of information, finance, real estate investment and people will be critically important to boost growth and upgrade the economic position of cities across Britain. As one of the world’s most urbanised global macro-regions, the European system of cities collectively connects it to major cities in distant globalization regions – the US and the rapidly emerging economies in Eastern Asia and China.

In a volatile world economy, strengthening the capacity of Europe and its cities to respond to very rapid global changes in a coordinated way will become ever more essential.

Kathy Pain is a professor of real estate development and a research director in the University of Reading’s Henley Business School. She holds a PhD in geography and is a Corporate Member of the Royal Town Planning Institute and a Fellow of the Royal Geographical Society. She has published extensively on the sustainable economic and spatial development of global mega-city regions. Her research has informed academic and policy thinking in the UK, Europe, North America, the Middle East and Pacific Asia.

As Greek citizens prepare for what could potentially be the most important referendum in a generation, Louis-Philippe Rochon, James Galbraith, Theodore Koutsobinas, Arne Heise and Philippos Sachinidis consider the arguments for and against exiting the eurozone.

There is a certain irony in reading the lyrics to the 1981 song by the Clash. In a way, it reads like it could have been written by Homer today, describing the European drama unfolding before us: “It’s always tease, tease, tease. You’re happy when I’m on my knees … If I go there will be trouble … Should I stay or should I go?”

The current ‘clash’ being played out in Europe at the moment between Greece and, well, everyone else, is certainly partly about economics. After all, the Greek economy has shrunk by close to 25% largely as a result of the draconian and absurd austerity policies imposed by the ‘institutions’ and Germany. Any more austerity will certainly reduce Greece to a pittance of its former self. In this sense, Greece is correct in opposing continued austerity and the imposition of primary surpluses. So far, the troika’s handling of the crisis has made things far worse, not better.

But there is certainly more going on. When witnessing the struggles of a small country like Greece trying to push against the formidable force of the institutions-formally-known-as-the-troika, we cannot but wonder if this drama is as much about economics as it is about the exercise of power and control. Imagine what would happen if independent and sovereign countries actually tried to exercise that frightful ‘D’ word. After all, isn’t democracy always the rallying cry of the oppressed? The gall of those Greeks! Oh wait, they did invent the concept, no?

Moreover, this power struggle seems to have another very specific aim: to crush left-thinking political parties like Syriza and Podemos, in Spain.

What is at stake is considerable. One could say without exaggeration that we are truly seeing the future of Greece unfolding. Greece faces a dark future, irrespective of the path it chooses. The question simply is: which path is less painful?

So, Should Greece leave the Euro?

There are, in my opinion, only four possible paths. These are:

The status quo with continued austerity

The status quo without (or with less) austerity

Political union and integration

Grexit

The first possible scenario is simply the current status quo, with continued austerity measures imposed by Germany and the Troika, despite the fact that considerable research, much of it within the IMF itself, showing how austerity does not and will not work. Under this scenario, Greece will agree to implement whatever policies are dictated to it. Greece will continue to aim to have annual primary surpluses by whichever means possible, which in the end will condemn it to depression-style existence, with possible contagion effects contributing to the eventual imploding of the European economy.

Our second option is the satus quo with less austerity. I doubt this could happen in the current political and ideological climate. But let’s assume it occurs through the divine intervention of Zeus himself. While certainly presenting Greece with some much-needed room to breath, it fails to address the flaws of the Euro itself: an illegitimate arrangement that consists of a monetary union without political union. Eventually, deflationary pressures will take hold again and we would simply repeat history.

The third scenario, that of political union with a monetary union, represents a major institutional change that would resolve much of the problems in the previous scenario. Indeed, as many heterodox economists, in particular my good friend Alain Parguez, have been saying since the creation of the Euro, you cannot have monetary union without political or fiscal union. But this path must be rejected as a non-starter: there is no political will in Germany to share its wealth with countries that she sees as victims of their own fiscal mismanagement and incompetence. Yet, short of leaving the Euro, this scenario would be quite acceptable as it would create a true European federation, with automatic transfers between the rich and poor countries, which could in many respects, minimize the impact of austerity. But it will never happen and so it is really not worth considering further.

This leaves us only with the last option: a true grexit. Under this scenario, Greece would leave the Euro, and either return to the drachma or create another new currency. In doing so, Greece would gain something considerable: monetary and fiscal sovereignty. Of course, the road ahead would be fraught with considerable darkness. Such a strategy would have to be accompanied by a panoply of reforms and policies: some capital controls, massive state intervention, reforms of the tax system (taxing capital gains), and more. It would not be an easy path, but it is I believe the most logical and least painful one.

The decision therefore comes down essentially to two extreme positions: either the status quo or a grexit. Both routes are perilous, indeed. So the decision is between more austerity and no future, while remaining a slave to the troika, or, full independence, control of its own monetary and fiscal policies, and certainly some difficult, but in no way impossible, times ahead.

If heterodox economists are unanimous in their support of Greece’s anti-austerity politics, there is far less agreement as to whether Greece should leave the Euro, or remain a faithful lapdog within it. Yet, this indecision only reflects the deep, and complicated issues at hand. There are not only economic issues, but political, social, historical and geopolitical questions to consider.

Despite the certain difficult situation and the considerable uncertainly regarding the possibility of abandoning the Euro, Greece would gain control over its future, and hopefully the right policies adopted to ensure prosperity.

In so many ways, a Grexit is the only possible and logical outcome to this austerian imbroglio.

**

James Galbraith, Lloyd M. Bentsen Jr. Chair in Government/Business Relations and Professor of Government at the Lyndon B Johnson School of Public Affairs.

The elected Greek government will not exit the Euro. It is philosophically pro-European. It has no mandate to exit the Euro. It cannot be forced out of the Euro or the European Union.

For these reasons, the question is moot. The only issue on Sunday is whether the Greek people accept or reject the conditions demanded by the creditors. If they say “no”, the government will go back to the negotiations. What happens then, will be up to the European partners and the IMF, and not to the Greeks.

The shameful threats leveled Monday about the referendum were not about what Greece should do. They were about defeating the Greek government in the referendum, and securing a more compliant debt colony in Greece. That could happen – but it would be unlikely to last long. There is such a thing as Pyrrhic Victory.

In that case, down the road, when the Nazis are the official Opposition, you might try posing this question again.

After five years of austerity and depression in Greece, the success of the left coalition Syriza was built on the maximalist premise that it could deliver the same financial aid with fewer austere measures than its predecessors. However, while with its Thessaloniki election program it promised 15 bn. Euro in money transfers, its last proposal to the lenders last week included 8 bn Euro of payments. This implies a 23bn. Euro difference, which is hard to swallow. So now that this political promise appears a naked lie, Syriza gives up the responsibility for its own failure to deliver, passes the hot potato to the Greek public and calls for a referendum to be held on Sunday with banks closed and pictures of queues of miserable Greeks creating a shock to the world.

Yet, there are apparent signs of international sympathy to a NO vote on the basis that during the negotiations the troika was not democratic. In contrast, it sought to help replace the Greek government and, eventually, it made Tsipras an offer he could not accept. This is the easy conclusion to make as some of the lenders like France and Italy support Greece. More importantly, the strategy and the the overall attitude of the Greek government during five months of negotiations with the Troika did not create also the necessary trust to move forward. Evidently, a substantive part of the blame goes also to the Greek government.

This is so because in February 2015, the Syriza government signed an agreement with the Troika of institutions about conducting negotiations for the continuation and completion of the on-going aid program. Restructuring Greek debt was never a prerequisite for coming to an agreement, although mention was made to a restructuring promise of Troika in 2012 to the then modest Greek coalition government once sustainable surpluses appear. While it was never meant to be considered by the lenders during this phase of negotiations and this was made repeatedly clear by key players, the debt restructuring issue was used deceptively by the Syriza negotiation team at the very last minute as an excuse to call a referendum.

The Greek government could obtain a much better deal than its last offer in the beginning of the negotiations. It chose instead to consume itself in playing game-theory manoeuvres, endless rhetoric, and shameless bluffing. Syriza officials promised the Greek electorate that “we will annul the memorandum with one law”, “we will ask help from Russia”, “we will join BRICS”’, “we will create a global financial turmoil with the collapse of negotiations”, “we will make it Kougki” – a reference to Harakiri threats – and so on, none of which materialized while some caused universal amusement. So, with the memorandum program coming to an end, Greek bets have run out and the referendum was called. After Tsipras arguing publicly that “there will be no referendum”, “banks will not close”, “we will pay the IMF on 30th of June”, “pensions will be paid normally”, he now claims that he guarantees personally; there will be no haircut in deposits” with no sufficient cash and no ELA support from ECB. Apparently, there is a trust problem in those negotiations but this does not concern only the lenders but gravely also the Greek government.

In addition, the referendum was called because the primary concern of Tsipras was the unity of Syriza party. Several hardline factions made earlier clear to him that they would not support an agreement of 23 bn.Euro difference in the parliament. As a result, the authority of Tsipras in the party and his political future are no more sustainable and those are the only reasons that he called a referendum, despite appeals to democratic values.

There have been many complex arguments in favour or against a YES vote. I opt for an easy but sensible reason. Syriza government supports a NO vote, the implications of which are very uncertain, because it does not minimize the failure of negotiations and the return to drachma, quite the contrary. Yet, economic depression in Greece during the last five years does not mean that we are left only with one solution, that is, drachma poverty at the name of anti-austerity. On the contrary, there are variable solutions and the Greek people is not obliged to choose only between the potentially good, the bad and the worse. The vote to YES is more probable to bring Greece to have a future so that it looks like Portugal, a degraded but promising economy of the European south rather than like transition Balkan countries such as Romania and Bulgaria. Neither are good options, but one is obviously worse than the others. For this reason, Greece must return to developing common ground with the lenders.

In the end of day, this referendum which, contrary to contentions of the Syriza government, is staged in a way that falls short of international democracy standards according to the Council of Europe with its ballot distortions, short campaign period and vague question, YES or NO on the proposal of lenders at a given date, makes sense only whether it means an answer to stay or exit Euro. But in doing so, the Greek electorate will actually decide whether it is the Syriza government as it is now, or a new coalition government that will be legitimate to attempt to come to a final agreement with the lenders. Yes, it is about politics again. Yes, Greece can stay in the Eurozone but the less risky way for this to happen is a YES vote for all that it means.

**

Arne Heise, Professor of Economics and Public Governance at Hamburg University, Germany

First of all, it should be pointed out that the question of whether Greece should exit the Euro is not equivalent to the question of whether Greece should have been kept out of the Euro in the first place. Although the answer to the latter is arguably ‘yes‘ as Greece did not fulfil the requirements of nominal, real and institutional convergence necessary to participate beneficially in a common currency, the answer to the former question is more difficult to answer for two reasons:

The short term costs for Greece of break-away from the Eurozone are too uncertain to be rationally compared to potential long-term benefits.

It is not merely the participation or non-participation in a common currency which is beneficial for Greece (and any other participant) but the way the Eurozone is governed.

Let me elaborate a bit on the last point: I have argued in a forthcoming article in the Review of Keynesian Economics (ROKE) that the European Monetary Union (EMU) faces an ‘inconsistent triangle‘ which means that a neoliberal economic policy orientation (‘Brussels-Frankfurt Consensus‘), the long-term survival of EMU and popular support for EMU cannot be squared. Or to put it differently: if there is enough political will to guarantee the survival of EMU and popular support is seen as necessary, neoliberal policies cannot be pursued much longer. Or: If neoliberal policies are to be defended as much as the EMU project, this will harm popular support and deform democratic decision-making further (beyond the endemic and well known ‘democratic deficit‘ in the EU). Moreover, Greece appeared to be a point in case: the neoliberal austerity measures enforced by the ‘institutions‘ caused a severe decline in support for EMU in Greece and washed a left-wing government in office which was very critical in continuing Greece’s participation in EMU.

Until the ‘Greece tragedy‘ unfolded, I used to argue that unshakable political support for EMU from the European (political and economic) elites would be the best possible way to change policy orientation as long as popular support in functioning democracies in Europe is regarded as a necessary condition. And Greece’s left government – probably with support from other (new) governments in southern Europe – may become the required ‘change agent‘. However, I considerably – and maybe naively – underestimated the resoluteness by which the European elite defend their neoliberal policy stance, risking a (at least partial) dissolution of EMU and accepting a further degeneration of democracies in Europe.

On the weekend, the Greek people have the choice between accepting the conditional support of the institutions implying a rather certain outlook of bleak economic and social developments for the nearer future on the one hand and the utterly uncertain short-term consequences and only very vaguely better long-term outlook in case of a break-away from the common currency on the other hand. In any case, the result will be disastrous for European integration as it either marks a turning-point in the history of ever deeper integration or the assurance that preferences of the populace are disregarded in a European Union which is unwilling to change its neoliberal orientation.

If a ‘no‘ from this weekend’s referendum would not merely mean to leave Greece behind but to make the European leaders think again about the deeper implications of such a vote (taking into consideration that still the majority of the Greek people would like to stay in the Eurozone!), there could be a chance for curing the ‘European disease‘ – admittedly, this looks naive right now.

**

Philippos Sachinidis, Former Minister of Finance, Greece

‘Grexit is not an answer to the problems of the Greek Economy’

Over the last five years some economists have argued that an exit of Greece from the Eurozone will benefit the growth prospects of the Greek economy. However there are good reasons to argue that a Grexit will have disastrous consequences for the Greek economy and the living standards of Greeks.

In the event of a Greek exit from the euro with no access to financial markets and\or funding provided by a program with institutional creditors, the economy will face two key financial constraints:

The current account deficit will have to be in surplus to ensure the necessary net inflow of foreign exchange to finance imports and cover external debt repayments.

The budget deficit would need to be balanced with a sudden reduction in spending or would have to be financed by the country’s central bank through the issue of a new currency. The inflationary pressures will lead to a hyperinflation.

A euro exit also implies that Greece will default on a large part of its foreign debt. Without defaulting on a substantial part of debt service obligations, the combination of devaluation and recession would push to even higher levels the total external debt and create the need for a greater and unattainable current account surpluses in order to meet foreign debt repayments. Thus, Greece will have no other choice than to default on an important part of its foreign loan obligations.

Inflation will rise pushed up by the monetization of the deficit and debt repayments, the impact of the devaluation on the CPI through the higher price of imported goods and services, together with the pressure for adjustment of nominal wages.

Following the country’s transition to the new currency, the living standards of Greeks will fall dramatically as their real income will fall. The wealth of Greeks, including the value of property and deposits, will undergo a similar sharp decline.

The argument that Greece’s exit from euro would enable the country to enhance the competitiveness of its economy through the devaluation of the currency has no substance.

Most of the key export sectors of the Greek economy, as well as a significant part of production intended for domestic consumption, rely on imported raw materials and imports of intermediate and capital goods which it would be difficult for them to obtain due to the limited access to foreign exchange.

Consequently, they would be forced to reduce their output, put their survival into doubt, in turn hampering further firms’ ability to access financing and causing many in the private sector to default on their obligations with their overseas creditors.

The tourism sector – often discussed as a main beneficiary – would be unable to fully benefit since due to the geography of Greece it is particularly exposed to factors related to transportation costs and energy prices, which would absorb a significant part of the benefit gained from depreciation. In the short term at least, the tourism sector would also be severely hit by the uncertainty caused by the country’s international default.

In addition, the likelihood of increased pressure to recover salary losses resulting from domestic inflation would lead to even higher inflation than envisaged in our baseline scenario, gradually undermining any gains in competitiveness deriving from the initial devaluation.

In such conditions investment and consumption will collapse and unemployment will rise to even higher levels.

In distributional terms, the only ones to gain from a Grexit will be wealthier Greeks whose assets are already denominated in other currencies and reside abroad. The most vulnerable part of the population will be the first victims of a Grexit.

In the third part of this Elgar Debates series, former Minister of Finance Dr. Philippos Sachinidis replies to Professor Steve Keen. To follow this debate from the beginning, read the first and second letters.

Dear Steve,

I would agree with you in that in order to understand the nature of the current Greek crisis one has to focus on the structural problems that led to the chronic current account imbalances rather than on the causes of the general government imbalances.

It is also correct to argue that the sharp fiscal consolidation deepened and prolonged the recession. Note, however, that Greece was in a recession since 2008 i.e. two years prior to the adoption of the adjustment programs.

In fact that was the main point of my letter; in order for Greece to restore growth and address the issue of unemployment and social inequality there is an urgent need to attract resources i.e. private investment in the tradable sector of the economy.

That would allow the Greek economy to revive its productive potential and capacity that was ruined during the period of the crisis, and to restore its price competitiveness that was lost after joining EMU.

Historically Greece suffered from chronic current account imbalances that, after the collapse of Bretton Woods, were mainly corrected, as mentioned in my first letter, by a combination of competitive devaluations and short-lived painful adjustment programs.

These imbalances triggered a number of crises in the 1980’s and 1990’s rather than the increase in private debt as you emphasize in your first letter, since private debt was then well below 40% of GDP one of the lowest among EU countries. These crises reflected the deep structural problems of the Greek economy.

Current account imbalances widened since Greece joined EMU because there was no corrective mechanism in operation as was the case when Greece had its own national currency.

To many observers the current account imbalances of a country member of a monetary union was not an issue for concern; is the current account deficit of the state of Massachusetts a concern?

This may explain why markets paid no attention to the widening current account deficit of Greece after joining EMU. It is only now, in the context of the New Stability and Growth Pact, that the European Commission explicitly takes note of these imbalances through the adoption of Macroeconomic Imbalances Scoreboard (MIP). This procedure explicitly monitors both internal and external imbalances.

However, from what we have experienced it looks as if the EMU resembles the gold exchange standard in that the only corrective mechanism to restore external imbalances is deflation, recession and huge unemployment.

In other words I am arguing that even without the fiscal crisis of 2009, when the fiscal deficit reached 15.5% of GDP and caused Greece to lose access to international capital markets, the Greek economy would have to restore its current account imbalances: there was no other way.

The only corrective mechanism would have been for Greece to run a lower inflation than the rest of the Euro area in order to restore its price competitiveness. And of course apart from being painful, this adjustment path usually takes time to deliver a sustainable level of competitiveness.

However, the very low inflation rate in Eurozone, much lower in fact than the 2% ECB target, forces the Greek economy to correct its imbalances through deflation rather than lower inflation. This inevitably has adverse effects on the economy through various channels as private and public debt become more difficult to service. Fisherian effects are in operation.

It was only a matter of time for markets to change their perceptions on the resemblance of EMU with USA or Canada. That happened after the collapse of Lehman Brothers when the spread of the Greek 10-year bond vs German 10-year bond increased by more than 270 basis points between late 2008 and early 2009. What I want to emphasize is that the increase in spreads took place well before markets realized that fiscal sustainability in Greece was out of reach.

The main point of my analysis regarding the Eurozone crisis and subsequently the Greek crisis is that the Eurozone crisis is the combined result of shortcomings of the institutional framework of the Eurozone -deficiencies that were known from the time of its inception- and the failure of the financial markets.

The lack of a federal agency to supervise European banks, the lack of a central fiscal agency responsible for a common unified EMU budget and for performing fiscal transfers between EU Member-States, the institutional prohibition of the ECB to act as a lender of last resort in order to stabilize bond markets and banking systems, the failure of the European institutions to monitor closely the economies of the Eurozone member countries, were among the factors that contributed in the emergence of the crisis. The crisis will be resolved only when EU will be ready to address these deficiencies in full.

In order to address the growth problem in Europe -especially in countries under program- it is urgent to reconsider the growth strategy at both European and Greek level. Europe should increase spending through inter-European investment projects.

Greece needs to introduce a program of structural reforms and enhance its tradable sector by attracting private investment. Although structural reforms are necessary to improve growth prospects, they need time to deliver results. According to OECD, Greece was among the countries that introduced a lot of structural reforms over the last years but in the same period the recession became deeper and deeper. As a result, citizens lost their faith on the effectiveness of the economic program to pull the Greek economy out of the recession.

An effective structural reform agenda must be internally consistent. It has to be an integral part of a coherent restructuring strategy that aims to change the economy’s growth model in a sustainable way. In this respect, a simple cherry picking of “convenient” structural reforms from large un-weighted tool-kits or fragmented domestic reform initiatives is unlikely to deliver material growth returns.

With regard to future fiscal policy, Greece should target at lower primary surpluses in the next years. This will speed the exit of the economy from the vicious recessionary path it finds itself in. Returning to positive growth rates will make fiscal consolidation easier and will change the market perception on the sustainability of the fiscal stance.

Yours sincerely,

Philippos

—

Dr Philippos Sachinidis is a former Minister of Finance for Greece. He is a member the Movement of Democratic Socialists.

To follow this debate from the beginning, read the first and second letters.

In his response to Dr. Philippos Sachinidis’letter last week, Professor Steve Keen outlines the economic problems of austerity and argues that a misdiagnosis of Greece’s economic situation has lead to a Great Depression.

Dear Philippos,

In your letter to me you state that “the effectiveness of the solutions proposed by the new SYRIZA-ANEL coalition government depends, to a large extent, on whether the causes of the crisis have been correctly diagnosed. According to the government, the only challenge facing the Greek economy is inadequate demand”. You then go on to describe their remedies as “traditional national Keynesian policies” focusing on boosting aggregate demand.

I can’t speak for the Greek government, but I strongly doubt that they would accept this as an accurate statement of either their diagnosis or their remedies. Your successor Yanis Varoufakis has long argued that Greece’s key problem is its excessive level of government debt relative to the size of its economy. He also argued that Troika policies which were supposed to reduce this debt in fact depressed the economy by even more than they reduced public debt—thus making the problem worse.

The remedies he recommended prior to joining Syriza involved a number of ways to reduce this debt burden, without breaching current EU guidelines and without needing new EU institutions—the so-called “Modest Proposal” (developed in conjunction with Stuart Holland and Jamie Galbraith), as well as the ending of austerity. The debt reduction proposals couldn’t be raised in the context of Greek-EU negotiations in the first few weeks that Syriza was in power, but they remain in the background. So I don’t accept your characterization of Syriza’s diagnosis or policies.

Since I’m speaking for myself in this debate rather than the Greek government, I’ll start with my diagnosis rather than theirs. Remarkably, it has substantial similarities to yours, since you sensibly consider the impact of the flows of money into and out of the Greek economy from banks, government spending, and international trade. You state that to answer the question “why did national Keynesian policies fail between 2007-2009, at least in the case of Greece?”, one has:

to focus on current account developments. In 2007, the current account deficit was 14% of GDP. What does this tell us? Clearly, expansionary fiscal policy as well as the expansion of private debt [my emphasis] was not boosting the national income leading to the restructuring and modernization of production but mainly involved an increase of imports.

This observation contains the key to understanding why Greece had a crisis. While Greece certainly has its own specific problems—especially with its current account—in general, its apparent boom before the crisis and the crisis itself had much the same cause as in the rest of the OECD: a private debt bubble that burst in 2008.

Private debt grew rapidly before the crisis—on average by more than 10% of GDP per year. This added to the demand generated by the government deficit, counteracting the impact of Greece’s chronic balance of payments deficit of between 10% and 15% of GDP per year (see Figure 1).

Figure 1: Rising debt before the crisis, plunging after

Figure 2 shows the aggregate effect: a monetary stimulus to the economy of as much as 20% of GDP in 2006, followed by a staggering reduction of as much as 45% of GDP in 2012-2013. Though the scale of the decline may be exaggerated by some of the government debt rearrangements that occurred in those years, it is still a huge reduction in the money supply in Greece.

Figure 2: From monetary stimulus to monetary contraction

What has been the impact of this—to coin a Varoufakis-like phrase—“fiscal bloodletting” on the country’s excessive debt ratios? Almost nothing: as Figure 3 shows, private debt has flatlined at about 130-140% of GDP, while public debt has continued to rise.

Figure 3: Flatlining private debt as a percentage of GDP

The reason for this is that GDP has fallen faster than debt has been reduced, as Figure 4 shows.

Figure 4: GDP falling even faster than debt being reduced

So the EU-ordained frontal attack on government debt hasn’t worked, because it’s also been a frontal attack on GDP as well. Let’s compare that to the USA, where austerity has not been imposed. Aside from the huge scale of the Greek current account deficit compared to the USA’s, the US pre-crisis pattern shown in Figure 5 is very similar to that for Greece: demand was being pumped up by rising private sector debt, on top of a run of government deficits.

But after the crisis, the pattern is very different: the plunge in private sector borrowing was partially offset by a huge rise in government spending. This monetary stimulus to the economy slowed down and then reversed private sector deleveraging. Rather than hitting the depths that Greece plunged, with private debt falling by almost 15% of GDP per year, deleveraging in the USA reached a maximum of 5% of GDP per year and then reversed. By 2012, the private sector was borrowing once more, and it has continued doing so ever since—though not on the scale of pre-crisis borrowing.

Figure 5: Sectoral money injections in the USA - same scale as Figure 1
for Greece

The aggregate picture in Figure 6 shows why the USA has pulled out of the crisis, while Greece—and most of the EU—is still mired in it. The monetary stimulus to the US economy is now back to the scale of 2000-2002, while Greece is still net-negative after a horrendous plunge in 2012-2013.

Figure 6: US stimulus versus EU austerity

An economy can’t grow when its money supply is shrinking; yet that is the main impact of austerity, both directly and via the pressure it puts on the private sector to continue deleveraging. The fact that the US government ran huge deficits—without them leaking into equally huge current account deficits—explains why the USA is apparently over the crisis while Greece and the EU are still in a Depression.

But that doesn’t mean that government deficits are the panacea: America’s deficits successfully ended private sector deleveraging, but as a result its economic recovery is commencing with an unprecedented level of private sector debt—see Figure 7.

Figure 7: US debt levels over the long term

This returns me to my diagnosis of the key problem facing the global economy: excessive private debt, combined with the government conviction—and particularly in the EU—that this debt be honoured, rather than reduced or defaulted upon.

Figure 8: Excessive private debt is a global economic problem

While private debt remains at the levels shown in Figure 8, any economic revival is going to be short-lived. This has been Japan’s dilemma for a quarter of a century now—attenuated only by Japan’s huge current account surplus. This is the key problem facing Greece today, which austerity and the inability to devalue have compounded.

The Troika’s misdiagnosis of Greece’s woes as being due primarily to excessive government debt has forced a Great Depression on Greece, without the benefit of any substantial fall in its private debt ratio, and with the clear failure of an increase in the government debt to GDP ratio.

The core SYRIZA-ANEL policy that austerity should cease is at least a partial step in the right direction, since the EU obsession with controlling public debt has made the downturn worse without reducing the private debt overhang at all.

But being anti-austerity—let alone “traditional Keynesian”—is not enough. We also need to admit the mistake of allowing private debt to grow without bounds, and then reduce it, as it was during the Great Depression and World War II—but preferably without social calamities on the scale of those catastrophic events. The Greek tragedy is that, thanks to the Troika’s policies, it has experienced the equivalent of the Great Depression without the positive side effect of wiping its slate of private debt.

In a new series of Elgar Debates, Dr. Philippos Sachinidis, former Minister of Finance in the previous Greek Government, tells Professor Steve Keen what is wrong with the current Government’s economic strategy.

Dear Steve,

The recent parliamentary debate on the Greek government proposed plan, to restore growth and address the social crisis, is a fresh start for a discussion of the challenges facing the Greek economy and an assessment of the solutions proposed by the government.

Let us first turn to the data. After five years of unprecedented adjustment, the Greek economy recorded, for the first time in years, a primary fiscal surplus and a surplus in the current account.

This twin deficit correction was made possible at an enormous cost in terms of the national income, with the cumulative losses approaching 26%, and in terms of employment with more than 1.3 million unemployed. Social inequalities substantially deepened and a large part of the population finds itself below the poverty line.

This means that a lot needs to be done to restore growth potential, reduce social inequalities and bring the economy to a steady state of fiscal and external sustainability.

In this regard, the effectiveness of the solutions proposed by the new SYRIZA-ANEL coalition government depends, to a large extent, on whether the causes of the crisis have been correctly diagnosed.

According to the government, the only challenge facing the Greek economy is inadequate demand. Dealing with the current lower levels of demand will bring back Greek economy to acceptable levels of welfare and lower unemployment.

Therefore, priority should be given to enhance demand via three channels.

– By increasing public investment

– By raising the minimum wage and by increasing pensions by around 8% (a 13th monthly pension) to those with a monthly pension below 700 Euros per month

– Finally, through extended tax reductions in order to indirectly enhance the disposable income of households with lower income.

This is a classic recipe to remedy economies with weak demand and it has proved itself to be quite effective in the short run, especially when applied in relatively closed economies with their own currency.

How effective though can these policies be when one is a member of the Eurozone? Experience does not tell us much, at least in the case of Greece.

New Democracy’s government led by Mr. Karamanlis, in their attempt to avoid the negative shock from the global financial crisis, followed the same path in 2008 by increasing deficits between 2007 and 2009, but still failed to avert the recession.

This solution led in the doubling of the government deficit, reaching 15.5% of GDP in 2009, but still the recession deepened even more; please note that the decline in GDP was 4.4% in 2009 compared to 0.4% in 2008.

Thus, one conclusion that maybe reached is that traditional national Keynesian policies contrary to expectations are not always and everywhere effective in handling recessions, especially in monetary unions.

So why did national Keynesian policies fail between 2007-2009, at least in the case of Greece?

To answer this question one has to focus on current account developments. In 2007, the current account deficit was 14% of GDP. What does this tell us? Clearly, expansionary fiscal policy as well as the expansion of private debt was not boosting the national income leading to the restructuring and modernization of production but mainly involved an increase of imports.

The fast paced increases in imports, due to the increased levels of borrowing, led to the closure of businesses and cancellation of thousands of jobs in Greece. In other words, the economy was on the wrong track.

If the country had a national currency, it would have collapsed under the pressure of speculators well before 2009.

In the past, in 1983 and 1985, while having a much smaller deficit in the balance of current accounts, Greece was forced to adopt tough austerity policies.

After joining the Eurozone, there was no national currency. To the extent that the markets were willing to continue lending both the private and the public sectors, though, we could continue financing an unsustainable deficit and a ballooning public and private external debt.

As soon as the international capital market changed their perception of Greece, the country lost its access to markets and sought the support of the institutional lenders. This means that Greece was no longer in a position to refinance public and private debt at a low and feasible interest.

It wouldn’t then be impossible for one to consider that if Greece repeats the national Keynesian recipe of 2007-2009, it would be highly likely to see an increase of imports along with a rising in the underlying cost of capital, limiting gains in terms of growth and employment.

Even worse the coalition government wants to launch an expansionary fiscal policy, without having access to bulk capital markets, while it is rejecting borrowing from institutional lenders at the same time. Therefore, the government’s recent programmatic announcements have an “Achilles heel” , this being the high cost of capital, which does not allow the effective financing of any business and government investment plan.

The solution, in order for the country to be able to tackle the huge economic and social problems in a sustainable way, lies in restructuring of the public administration but also in transforming the economy to become more efficient and outwards oriented.

This transformation can only be realized by attracting mainly private investors who would place their capital in the competitive and export-oriented industries.

We need to consider that the state budget is incapable of financing the more than 30 billion Euro investment programs in the next three years, needed to restore the productive pillars of the economy destroyed during the crisis or even before that. What is needed then is the creation of an environment that is favourable for investors.

Recession in Europe needs to be fought with a federal Keynesian policy, involving a new system of fiscal transfers followed by a consumption increase in the Northern countries along with Europe-wide projects together.

Nevertheless, changing our production paradigm is solely our responsibility. The positions taken by the coalition government are deafeningly silent regarding the boost in demand with private investment. This silence is not incidental. It has deep rooted ideological roots and political values, concerning the role of private investment in a mixed economy. These beliefs undermine the prospects of private investment involvement in the Greek economy, as a viable, alternative solution for sustainable growth in Greece.

Yours sincerely,

Philippos

—

Steve Keen’s reply will be posted next week.

Edward Elgar Publishing wishes to thank Louis-Philippe Rochon for his help in arranging this debate.

What are the best economic policies to promote a global recovery? Here, in the fourth letter of this debate, Louis-Philippe Rochon defends Keynesian theory and argues that austerity is causing great social as well as economic harm.

To follow this debate from the beginning, read Steve Kates’ first letter here. Then read Louis-Philippe’s reply, and then Steve’s reply to Louis-Philippe.

My dear Steven,

I read with much interest your most recent letter and I will confess I agree with you … we are indeed far apart! But surely this is not surprising as we both defend not only a very different vision of economic theory, but also a different vision of markets and society. At the core of our disagreement lies an understanding of markets, which you see as self-regulating, whereas I claim they are not. I view markets as chaotic and prone to instability and, quite honesty, capable of exploding (or rather deteriorating) into crises, with unimaginable consequences. Perhaps you are OK with that, but I am not. So when I said that the ‘worst infliction’ is to leave us exposed to the ‘tyranny of markets’, I meant precisely that: because of periodic crises, but also because of oft-occurring recessions, we cannot place our complete faith in free-markets. I see unregulated markets and unfettered capitalism as a scourge that must be tamed. To deny or ignore this would be a grave mistake, which would condemn us all to misery, and worse. How else would you characterize the massive inequality of income and wealth around the world and in particular in the United States, which is one of the most unequal developed economies? Is the fact that 40% of the wealth in the US rests within 1% of the population not a tyranny? Does this not shock you? It shocks me, and I will say it again: unless we address this calamity, we are bound to relive a crisis – and soon. Mark my words: another crisis is coming.

You seem to view markets as “the single most liberating institution in possibly the entire history of the human race.” Well, I can see where we disagree indeed. Markets are where goods are produced and sold, where incomes are determined. But they are not efficient, in the way that they do not always produce an optimum result; that is why we need some regulator and some other institution to intervene when markets fail. I would go further, I would argue that markets never allocate efficiently, and never perform optimally, so that there is a permanent and on-going need for the State to precisely regulate the cycles and minimize the pains that recessions and crises can inflict upon us, and to reduce the injustice of inequality. You say this is socialising our economies. I assume you say this in a derogatory way. I am by no means a socialist; like Keynes, I want to save capitalism from itself. But I will wear that label proudly if you meant it as somehow to denigrate. Rather, I see it as the only way of making capitalism work for mankind. In that sense, I stand proudly on the shoulders of Keynes and others who have defended that very notion. I will proudly stand and argue, supported by a vast literature of empirical research that the State is in a unique position, given its power to spend, to create wealth and prosperity for all.

You then suggest that my claim that economies grow from demand, both in the short and long term, is a mere statement devoid of a theory. Of course, you will pardon me if I did not, in less than 1,500 words, write a complete theoretical treatise on the economics of aggregate demand. But there is a vast literature on this topic, with which you are familiar I am sure, and well-developed theories, with considerable empirical support to buttress the argument.

But why are you so dismissive of Keynesian policies? The problem here, I believe, is your interpretation of what consists of Keynesian aggregate demand policies. Twice now you mention Keynes’s assertion that we should bury bottles full of banknotes as representative of Keynesian policy. My dear Steven, Keynesian economics is much more than that, and to isolate that sentence as representative of Keynes is both misleading and, well, dishonest. Keynes of course said much, much more, and Keynes was being more sarcastic than anything.

In fact, Keynes was clear, a bit later in the same often-quoted passage, that “It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing” (GT, p. 129). Did you not read that part of the General Theory?

Keynes’s message was that ideally, it would be better to build houses, or roads and bridges than to do nothing, the latter condemning us to misery and, yes, the tyranny of the markets. Keynes’s point about the bottles is that even something as silly as that would be better than doing nothing.

I suspect your insistence of that quote as an example of Keynesian economics is perhaps more sinister, knowing full well of course that the population would instantly be opposed to the silliness of that policy. So you must admit, there is some treachery afoot in your argument. If we are to have a dialogue, you cannot reduce the Keynesian edifice to ‘wasteful projects’. I know that you know that Keynesian economics is more than digging holes: there are large infrastructure projects and public investment. I suspect if we explained to the masses that Keynesian policy is about infrastructure, investing in the future, social justice and building civilizations, then I am convinced that they would see the wisdom residing within it.

Now regarding that ‘piece of arithmetic’, which you call the Y = C + I + G + (X – M), I am afraid that is simple national accounting, no more no less. But more than that, for me it is a point of pure logic: when consumers, private firms or governments spend, that increases the demand for goods, which firms must produce. Please, tell me where the flaw in that logic is? And when the private sector is incapable or unwilling to spend, governments must above all step in to sustain that level of demand, which will be hopefully met by the private sector producing.

I was struck at how different we interpret history, and recent history at that. I must admit I am at a loss for words. Keynes once famously said, “When the facts change, I change my mind. What do you do, sir?”, but I fear that no matter what I say, or in fact anything you read anywhere by anyone won’t change your mind. I think perhaps if you got away from digging holes as representative Keynesian policies would be a good start.

In closing, let me address what I consider the biggest lie in economics at the moment: the idea that reductions in government spending will lead to higher economics growth. This is pure theoretical poppycock. For instance, in Europe, it has proven to be disastrous. Austerity never works. After a few years of austerity, Europe is no closer to sustained economic growth as before. For instance, in France, after imposing several fiscal cutbacks, the government expected deficits of 2.2%. Austerity now translated into deficits running at double that, at 4.4%. This is because of that piece of arithmetic: austerity leads to depressed demand and economic activity that then deflates the entire system, more proof that demand is what matters. Policies based on supply do not work, never work, and never shall work. It is pure fantasy to believe that anything but demand is the driving force of economic activity. So we may not all be Keynesians now, but the real world is, and it operates along lines described by Keynes and Keynesians. And the General Theory, while written over 75 years ago, like you point out, remains to this day the best guide to successful macroeconomic policy we have. Granted, it needs updating, but the basic logic of the book is as relevant and as important today as it was back when it was published.

You say that what we need is value-adding production, and not just building brick walls as you put it. I completely agree. But, my dear Steven, that is what Keynesian spending does: by contributing to infrastructure building, by contributing to crowding-in, it value-adds to society.

In conclusion, the empirical evidence is squarely on the side of Keynesian economics and the importance and vital role of aggregate demand and the State. To advocate for free markets under the illusion of the efficiency dogma is pure nonsense and self-delusional. As Keynes said, that would be disastrous if we tried to apply it to the facts of experience. The real world is government by Keynesian laws, and any attempt to deny and interfere with those laws can only result in more hardship.

Finally, let me leave you with this wonderful quote by Keynes: “the man who regards all this [public expenditures] as a senseless extravagance which will impoverish the nation, as compared with doing nothing and leaving millions unemployed, should be recognized for a lunatic.” (Collected Writing, Volume XXI, p. 338).

Best wishes,

Louis-Philippe

Steve Kates’ second letter, replying to Louis-Philippe’s first. Published on 27th November 2014

Dear Louis-Philippe

Thank you very much for clarifying so much in your letter. But from its very subheading – “The worst infliction we can impose on our economies is to leave them to the tyranny of the markets” – I can see how far apart we are. To think of markets as a “tyranny” when they have been the single most liberating institution in possibly the entire history of the human race puts us very far apart indeed.

And to assume that we might even remotely disagree on the need for market regulation can only mean you have not understood what I wrote. There are an astonishing number of techniques and approaches available to manage an economy, with public spending to get an economy out of recession only one amongst this vast array. If you are going to start with the assumption that not trying to spend our way to recovery is the same as laissez-faire then there is no possibility of ever understanding what critics of Keynesian economics are saying.

Perhaps that is just the title. What more does your letter say? Let me look at a number of your assertions, starting with this.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. . . . Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect!

This is merely a statement without benefit of theory. Raising aggregate demand has a superficial appeal to those who don’t understand how an economy works. But if you said that people who counterfeit money and spend it are also promoting economic growth and employment, everyone would immediately see the flaw in your reasoning. The great error in Keynesian economics is to assume that expenditures without the backing of real value adding production can in any way raise living standards and increase employment.

The fact is there is no substantive theory to back your assertions. There is that piece of arithmetic – Y=C+I+G+(X-M) – and there are a handful of diagrams. But there is no actual way to explain why spending on wasteful projects will cause an economy to expand. There is famously no micro to go with Keynesian macro. There is no theory to explain at the level of human interaction how any of this would work in the real world.

You say instead we have historical experience as evidence. You wrote:

My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction.

You may assert all you like that Keynes saved capitalism but what are the facts? First, The General Theory was published in 1936, three years after the Depression had come to an end in virtually every economy, which, moreover, was achieved through the application of classical economic policies which included cuts to public spending. In the United States, however, the Depression dragged on until the coming of the war in 1941, a delay due in large part to Roosevelt’s attempts at a prototype Keynesian stimulus.

But think of this. Those three wonderful post-war decades were preceded by the decision of the United States in 1945 to immediately balance its budget. The massive wartime deficits were brought to an end right then with no delay, and a balanced budget put in its place even with millions returning to the workforce after being mustered out of their wartime military service or from their jobs in wartime industries. The Keynesians of 1945 all wanted a continuing deficit. Truman turned them down flat.

How does a Keynesian explain any of that? Why should demand have been more “pent up” in 1945 than it was in 1935? We are instead reminded by you of the supposedly woeful economic outcomes of the 1980s, which I must confess not to remember in quite the same way as this:

By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates.

The real contrast, of course, is with the 1970s, the greatest period of Keynesian disaster until the one we are in the midst of now. How could you leave those years out – the catastrophic stagflation of the 1970s? What do you have to say about the 1970s?

Meanwhile, the only reason you can offer for the stimulus not working following the GFC is because it ended too soon.

While governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures.

One could only wish the stimulus had merely lasted a single year. The US is the paradigm example. Despite Congressional attempts to reduce deficit spending, the attempt to contain public expenditure in the US only seriously began with the “sequester” in 2013!

And indeed, the White House specifically dates the commencement of sequestration from the first of March that year. If ever a stimulus was given time to work itself out, it was then. The disastrous response of the American economy to the stimulus is perfectly in line with my own expectation. Your belief that conditions were improving until the sequestration began can only mean we are living in a parallel universe.

But how much we may differ on the timing when restraint finally began, we can certainly agree on the current disaster. You may think it’s because the stimulus was prematurely brought to an end. I think of it as the inevitable consequence of a Keynesian policy. You think it is deficient aggregate demand, that empty bit of Keynesian rhetoric. I think the problem is structural.

The theory you evade is recognition that our entire economic structures are now so distorted through public spending and “quantitative easing” that our economies are having great difficulty finding a productive base. To think this is deficient demand is to mistake the symptoms for the cause.

So on this much at least we can agree, that the world’s economies are in a mess: consumers deep in debt, savings eaten away by low productivity, government spending, and private investment going nowhere. And I didn’t just say the stimulus would not work; I said the stimulus would make things worse. You describe what I see, but I expected things to end like this from the start.

You only began to recognise a problem more than a year later, and only because by then it was obvious to all and sundry that in every place the stimulus had been introduced economic conditions had continued to deteriorate. You nevertheless still continue to believe, in spite of the evidence, that the problem is not enough government spending.

This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

The plain fact is that there has never been a single instance in the entire period since The General Theory was published where a public sector stimulus has been able to bring a recession to an end. There’s not a single example, not one, with the coming of World War II the only supposed example when unemployment ended mostly because half the male population under 30 was put into the military.

It is not aggregate demand that matters, but value adding production. You must do more than build brick walls, you must build where what is built actually contributes to prosperity. To think more holes dug up and then refilled can generate recovery because it constitutes “fiscal spending” is the essence of economic illiteracy. And if we were looking to make matters worse, it’s hard to go past items 1-3 of your program for recovery:

First, we must replace private debt with public debt.

Second, we must put job creation above all other goals.

Third, we must deal head on with the problem of income inequality.

That is to say: we must socialise our economies.

Private debt is incurred by private sector firms. To replace this debt with public debt would so obviously drive us into deep recession that it is almost impossible to understand why this is not perfectly clear to you. And as for creating jobs – which everyone seeks to do, not just Keynesians – the fantastic proposition that governments will be able to choose productive value-adding forms of expenditure is an illusion. Your plan is to redirect the source of expenditure to the people least capable to choosing where the most productive investments would be found.

I’m afraid your program would be part of the problem and in no way part of any solution. I fear that three quarters of a century after the publication of The General Theory, economics is now at such a low ebb that what you have written will look like perfect sense to all too many, even as every attempt in the past to do what you have suggested has made things worse than they already were.

In times gone by, before Keynes, economists talked about “effective demand”, that is, what was required to turn the desire for products into an ability to buy those products. Now it is aggregate demand – the total level of demand – which has leached the original concept of any appreciation that for everyone to buy from each other – to raise aggregate demand as you might put it – they must first produce what others wish to buy. A freshly dug hole that is immediately refilled will not do even if money is paid for the work. If that is not obvious, then common sense has gone from the world.

But I say again. A short post cannot state everything that needs to be said. For a more complete explanation of these issues and what needs to be done, you must turn to the second edition of my Free Market Economics. It’s still not too late, but it is getting later all the time.

Kind regards

Steve Kates

Louis-Philippe’s Reply to Steve’s First Letter – published on 20th November 2014.

Dear Steven,

Thank you for your letter, which I was happy to read. I must confess, however, that we seem to have very different memories of this crisis (a word, by the way, that never appears in your letter) and an extremely different interpretation of the history of macroeconomics. I also don’t quite understand your passion against anything Keynesian. My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction. For that, he is remembered as one of the greatest thinkers. By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates. As you say, ‘you be the judge’.

You also suggest that Keynesians were wrong in their predictions of the duration of the crisis and you are undoubtedly right about Akerlof. But many other Keynesians were also predicting a long and worrisome recovery. And may I add, virtually no one in the mainstream of the profession, including Austrians, Libertarians and neoclassical economists, predicted this crisis. They were too busy with their badly-designed models to pay any attention to the real world. So, yes, I point a finger to neoclassical economists who believe in the Efficient Market Hypothesis which even denies such a crisis can occur. For that reason, they could not even see the crisis until it was right under their noses. Funny enough, at conferences a few years after the crisis began, those same economists were back to business as usual as if the crisis never happened. Surely, you are not asking me to have faith in the same theories that directly contributed to the greatest crisis in over 75 years.

As a “post”-Keynesian (not to be confused with ’Keynesian’ new, neo or other), I too predicted at a talk I gave at UNAM in Mexico in 2009 that this was going to be a long, dragged-out crisis, and even stated at the time that it was going to take at least a decade to recover. Many of my colleagues on the left made the same arguments. And, here we are seven years later. But now, I think I may have been wrong: I think it will take much longer.

But the reasons I gave then are even truer today: while governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures. You say, “we had the stimulus” but forget to mention that the stimulus policies were completely reversed a mere year after they were introduced. And make no mistake: that stimulus was working. We were well on our way to recovery until governments got spooked by those who were warning against high deficits and debt levels, and who bought into the fear-mongering propagated by the right that governments were going to go bankrupt if they spent beyond their means. Well, we know what happened, don’t we?

First, the embarrassing gaffe (to put it mildly) by Carmen Reinhart and Kenneth Rogoff, whose paper, ”Growth in a time of Debt”, was widely cited as empirical proof that too much debt can harm growth. Well they were quickly defrocked and their research exposed for what it truly was by an honest doctoral student from University of Massachusetts, Amherst, Thomas Herndon, who took the time to properly dot the i’s and cross the t’s. So that myth was clearly debunked. In fact, UNCTAD just released a new report indicating that among the top 7 countries with the worse austerity measures are Italy, Spain, Portugal, Greece and Ireland – all countries facing a dire economic situation. You be the judge.

Second, we now know that any country with a sovereign currency can never go bankrupt since a sovereign central bank can always buy all the required government debt.. And financial markets and speculators know this. The proof is in the pudding: while the US, the UK and Japan’s debt levels were much higher than many other countries, their interest rates were much lower. Clearly, financial markets know exactly this to be the truth and did not turn away from the US when the debt levels were climbing.

The worst infliction we can impose on our economies is to leave them to the tyranny of the markets. We now know with conviction that markets are by their very nature unstable and prone to crises, and must be regulated. Unfettered markets only lead to recessions and crises at which time governments must swoop in and clean up the mess.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. When the private sector is not spending, governments have the moral responsibility to intervene and ensure the spending is sufficient to encourage investment. Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect! When you look at aggregate demand today, it is at best anemic. Consumers are saddled with debt, and private investment has flatlined; austerity measures are being imposed everywhere. There is no room for growth. That leaves only exports to ensure a recovery. But with Europe on the verge of deflation, the BRIC countries slowing down, the prospects for exports are dimming. So where will growth come from? I am afraid that without aggressive fiscal deficit spending, we are dooming future generations and ourselves to another decade or more of weak economic growth. This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

So what do we need to get the world economy back to prosperity? Here is my four-prong solution:

First, we must replace private debt with public debt. This can only occur with a well coordinated fiscal stimulus among the leading economies. Here in Canada, our infrastructure is crumbling and in desperate need of massive public investment. I can think of a number of places that need investment: our health care system, our education, our national parks, our roads and bridges, and why not create national day care to help struggling families. In the US and elsewhere around the world, there are plenty of examples of much needed infrastructure spending and public investment projects. If there is ever a good time to borrow, now is the time as interest rates are at historically-low levels. Governments engaging in austerity should be held criminally negligent for their actions.

Second, we must put job creation above all other goals. Work offers dignity, which every person deserves. This requires governments to adopt a policy of full employment. This would require as well a prolonged period of low interest rates, with an injection of fiscal cash. I am always in disbelief when I witness the cavalier-indifference policy makers have towards the unemployed. This must end.

Third, we must deal head on with the problem of income inequality, which is at the very core of the crisis in aggregate demand. Interestingly enough, income inequality was as pronounced right before the crash of 1929 as it was right before the crisis began in 2007. This leads me to suggest that income inequality is one of the causes of the financial and economic crisis. If governments do not address this problem, we are doomed to repeat the problems of 2007 before long. For starters, we need to have a higher marginal tax rate on the rich, a high wealth tax, an important increase in the minimum wage; we must also at all cost reign in corporate bonuses and inflated CEO paychecks, eliminate practices such as buy backs, and raise the corporate tax.

Fourth, with respect to Europe, well that’s a mess of a different colour. Yes, austerity has veered its ugly head there as well, but they also have to deal with the shackles of a common currency. They must either adopt the proper federal institutions to deal with the problems facing the Southern countries, or get rid of the Euro all together. This will undoubtedly create some short-term angst, but the consequences of the status quo are a few decades of deflation. The Euro was an ill-planned policy: you cannot have a monetary union without a political union.

So I end here by staying that had we had more Keynesian aggregate demand policies, we would probably not be in this mess today, which is entirely the result of anti-Keynesian, short-sighted policies designed to benefit the very few rather than the masses.

So my dear Steven, we disagree on many issues. I look forward to your reply.

Steve Kates’ First Letter, which began this debate – published on 13th November 2014

Dear Louis-Philippe

There are about as many versions of Keynesian theory as there are Keynesians but all versions have two things in common. The first is that economies are driven by aggregate demand. The second is that an economy’s rate of growth and level of employment can be increased by increasing aggregate demand, either through higher public spending or lowering rates of interest. Both are wrong and the destructive consequences of these beliefs are everywhere to be seen.

The following was written by two winners of the Nobel Prize in economics just as the fiscal stimulus was being introduced.

In the middle of the Great Depression John Maynard Keynes published The General Theory of Employment, Interest and Money. In this 1936 masterwork, Keynes described how creditworthy governments like those of the United States and Great Britain could borrow and spend, and thus put the unemployed back to work. (Akerlof and Shiller, 2009: 2)

This is what I wrote at exactly the same time.

What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome. (Kates 2009)

You be the judge. Who was right? We had the stimulus and the unemployed have not been put back to work. We are instead in the sixth year of recessionary conditions which have indeed been deep, prolonged and which will still take years to overcome.

In the 1990s, Japan, at the time the most dynamic and amongst the fastest growing economies in the world, attempted the same kind of Keynesian stimulus. Its economy has remained comatose ever since.

And then, of course, there was the Great Stagflation of the 1970s brought on by the direct application of Keynesian theory to the problems of the time.

You would think after such consistent failure people would begin to understand that the problem is Keynesian theory, the common factor in each case. But so powerful has been the grip of the theory of aggregate demand that in spite of everything, the theory has virtually never been questioned.

If anyone knows anything about what Keynes wrote, it is that recessions are caused by too much saving. Public spending is therefore needed to soak up those savings, which businesses either cannot borrow because expected returns are too low or won’t borrow because interest rates have not fallen far enough. Here was Keynes’s advice on the kind of response that was therefore needed:

If the Treasury were to fill old bottles with banknotes, bury them . . . and leave it to private enterprise . . . to dig the notes up again . . . there need be no more unemployment. . . . It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing. (Keynes 1936: 128-129 and quoted with approval exactly as shown above in Temin and Vines 2014: 50)

This has been the essence of Keynesian theory from that day to this.

There is unemployment because the community is saving too much. Something must be done to put those savings to work. For various reasons, the private sector cannot be depended on to use those savings and interest rates cannot be lowered far enough. Therefore, public expenditure to soak up these savings must be increased and it is irrelevant whether such expenditure is in itself value adding. Even if a government increases expenditure on projects that are purely wasteful, this spending will increase the total level of aggregate demand. The increase in aggregate demand will then lead to an increase in national wealth and a fall in unemployment.

The specific point made by Keynesian economists is that spending on anything will restore an economy to full employment and raise living standards.

A century ago it was obvious to every economist alive why a stimulus of this kind could not work. Today the problems with such an approach are invisible and apparently incomprehensible.

Certainly a government can itself employ, or can buy from others causing those others to employ. And those additional employees can use their incomes to buy things from others still. And so, for a brief period of time, we can say there has been an increase in employment relative to how many might otherwise have been employed.

But unless whatever has been produced is value adding, as time goes by these additional employees merely drain away the productive capacity of the economy. Savings are indeed absorbed but the value left behind is lower than the value used up during production. The economy not only remains stagnant, it winds even further down as its resource base is diverted into wasteful forms of expenditure.

Moreover, the resource base of the economy is not just misdirected into the particular goods and services sought by governments, but the inputs, whose production has also been encouraged by the “stimulus”, become a further distortion of what was already a grossly misdirected structure of production.

The structure of the economy has thus become even more misshapen than it had been when the stimulus began and the problem cannot be cured until the non-value adding components of the stimulus are wound back. You can call the process “austerity” if you like. But the fact is that there can be no solution to the problems the stimulus has caused until the various non-value-adding projects the government has introduced are withdrawn.

The adjustment process is inescapably painful, far more drawn out than recovery from the original recession would have been, but there is no alternative if an economy is ever to regain its strength. But because they think in terms of aggregate demand, no Keynesian ever understands what needs to be done.

Let me approach this in a different way. This is the fundamental equation of Keynesian economics (leaving aside foreign trade):

Y = C + I + G

Aggregate demand (Y) is the amount spent by consumers on consumer goods (C) plus the amount spent by businesses on investment (I) plus total spending by governments (G). The underlying presumption is that the higher the level of Y, the higher the level of output and employment.

In a recession business investment goes down, and as Y goes down, employees lose their jobs. To lift Y back up and therefore raise employment, the policy recommended by Keynesians is to raise the level of government spending on absolutely anything at all.

What you then have is less investment by business and more spending directed by governments. The proportion of expenditure on productive forms of output has been reduced while spending on less productive and often totally unproductive forms of output has increased.

No one wants recessions and the unemployment recessions bring. But a Keynesian response that attempts to lift aggregate demand without first increasing value-adding supply can never succeed. There is no mechanism that can lead from higher levels of wasteful expenditure to higher living standards and more employment.

That so many seem unable to learn from experience, or any longer understand the reasons why wasteful spending can never be a solution to recessions and unemployment, is the most astonishing part about having watched events unfold since the GFC.

Obviously, none of this can be properly explained in a brief note of a thousand words. If you are interested in understanding not only why Keynesian economics provides no solutions to our economic problems, but also what should be done instead, read the second edition of my Free Market Economics: an Introduction for the General Reader. There is literally nothing else like it anywhere.

Best wishes,

Steve

–

Bibliography

Akerlof, George and Shiller, Robert. 2009. Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton, NJ: Princeton University Press.

]]>https://elgar.blog/2014/12/04/elgar-debates-how-to-promote-a-global-economic-recovery-it-is-pure-fantasy-to-believe-that-anything-but-demand-is-the-driving-force-of-economic-activity/feed/2bank runkatyroperm and s george-marks-man-writing-letter-at-bureau_i-G-56-5638-JDIMG00Zjean-leon-gerome-a-collaboration-corneille-and-moliereSamuel_Johnson_by_Joshua_Reynolds_2GrantKeynesElgar Debates: How to Promote a Global Economic Recovery? “Markets… have been the single most liberating institution in possibly the entire history of the human race”https://elgar.blog/2014/11/27/elgar-debates-how-to-promote-a-global-economic-recovery-markets-have-been-the-single-most-liberating-institution-in-possibly-the-entire-history-of-the-human-race/
https://elgar.blog/2014/11/27/elgar-debates-how-to-promote-a-global-economic-recovery-markets-have-been-the-single-most-liberating-institution-in-possibly-the-entire-history-of-the-human-race/#respondThu, 27 Nov 2014 11:41:59 +0000http://elgarblog.wordpress.com/?p=4300

What are the best economic policies to promote global recovery? In the third letter of our new Elgar Debates series, Steve Kates challenges Louis-Philippe Rochon’s proposed strategy for economic stimulus, and suggests that the market is the best tool to develop recovery.

To follow this debate, begin at the bottom of the page by reading Steve’s first letter, and then Louis-Philippe’s reply.

Dear Louis-Philippe

Thank you very much for clarifying so much in your letter. But from its very subheading – “The worst infliction we can impose on our economies is to leave them to the tyranny of the markets” – I can see how far apart we are. To think of markets as a “tyranny” when they have been the single most liberating institution in possibly the entire history of the human race puts us very far apart indeed.

And to assume that we might even remotely disagree on the need for market regulation can only mean you have not understood what I wrote. There are an astonishing number of techniques and approaches available to manage an economy, with public spending to get an economy out of recession only one amongst this vast array. If you are going to start with the assumption that not trying to spend our way to recovery is the same as laissez-faire then there is no possibility of ever understanding what critics of Keynesian economics are saying.

Perhaps that is just the title. What more does your letter say? Let me look at a number of your assertions, starting with this.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. . . . Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect!

This is merely a statement without benefit of theory. Raising aggregate demand has a superficial appeal to those who don’t understand how an economy works. But if you said that people who counterfeit money and spend it are also promoting economic growth and employment, everyone would immediately see the flaw in your reasoning. The great error in Keynesian economics is to assume that expenditures without the backing of real value adding production can in any way raise living standards and increase employment.

The fact is there is no substantive theory to back your assertions. There is that piece of arithmetic – Y=C+I+G+(X-M) – and there are a handful of diagrams. But there is no actual way to explain why spending on wasteful projects will cause an economy to expand. There is famously no micro to go with Keynesian macro. There is no theory to explain at the level of human interaction how any of this would work in the real world.

You say instead we have historical experience as evidence. You wrote:

My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction.

You may assert all you like that Keynes saved capitalism but what are the facts? First, The General Theory was published in 1936, three years after the Depression had come to an end in virtually every economy, which, moreover, was achieved through the application of classical economic policies which included cuts to public spending. In the United States, however, the Depression dragged on until the coming of the war in 1941, a delay due in large part to Roosevelt’s attempts at a prototype Keynesian stimulus.

But think of this. Those three wonderful post-war decades were preceded by the decision of the United States in 1945 to immediately balance its budget. The massive wartime deficits were brought to an end right then with no delay, and a balanced budget put in its place even with millions returning to the workforce after being mustered out of their wartime military service or from their jobs in wartime industries. The Keynesians of 1945 all wanted a continuing deficit. Truman turned them down flat.

How does a Keynesian explain any of that? Why should demand have been more “pent up” in 1945 than it was in 1935? We are instead reminded by you of the supposedly woeful economic outcomes of the 1980s, which I must confess not to remember in quite the same way as this:

By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates.

The real contrast, of course, is with the 1970s, the greatest period of Keynesian disaster until the one we are in the midst of now. How could you leave those years out – the catastrophic stagflation of the 1970s? What do you have to say about the 1970s?

Meanwhile, the only reason you can offer for the stimulus not working following the GFC is because it ended too soon.

While governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures.

One could only wish the stimulus had merely lasted a single year. The US is the paradigm example. Despite Congressional attempts to reduce deficit spending, the attempt to contain public expenditure in the US only seriously began with the “sequester” in 2013!

And indeed, the White House specifically dates the commencement of sequestration from the first of March that year. If ever a stimulus was given time to work itself out, it was then. The disastrous response of the American economy to the stimulus is perfectly in line with my own expectation. Your belief that conditions were improving until the sequestration began can only mean we are living in a parallel universe.

But how much we may differ on the timing when restraint finally began, we can certainly agree on the current disaster. You may think it’s because the stimulus was prematurely brought to an end. I think of it as the inevitable consequence of a Keynesian policy. You think it is deficient aggregate demand, that empty bit of Keynesian rhetoric. I think the problem is structural.

The theory you evade is recognition that our entire economic structures are now so distorted through public spending and “quantitative easing” that our economies are having great difficulty finding a productive base. To think this is deficient demand is to mistake the symptoms for the cause.

So on this much at least we can agree, that the world’s economies are in a mess: consumers deep in debt, savings eaten away by low productivity, government spending, and private investment going nowhere. And I didn’t just say the stimulus would not work; I said the stimulus would make things worse. You describe what I see, but I expected things to end like this from the start.

You only began to recognise a problem more than a year later, and only because by then it was obvious to all and sundry that in every place the stimulus had been introduced economic conditions had continued to deteriorate. You nevertheless still continue to believe, in spite of the evidence, that the problem is not enough government spending.

This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

The plain fact is that there has never been a single instance in the entire period since The General Theory was published where a public sector stimulus has been able to bring a recession to an end. There’s not a single example, not one, with the coming of World War II the only supposed example when unemployment ended mostly because half the male population under 30 was put into the military.

It is not aggregate demand that matters, but value adding production. You must do more than build brick walls, you must build where what is built actually contributes to prosperity. To think more holes dug up and then refilled can generate recovery because it constitutes “fiscal spending” is the essence of economic illiteracy. And if we were looking to make matters worse, it’s hard to go past items 1-3 of your program for recovery:

First, we must replace private debt with public debt.

Second, we must put job creation above all other goals.

Third, we must deal head on with the problem of income inequality.

That is to say: we must socialise our economies.

Private debt is incurred by private sector firms. To replace this debt with public debt would so obviously drive us into deep recession that it is almost impossible to understand why this is not perfectly clear to you. And as for creating jobs – which everyone seeks to do, not just Keynesians – the fantastic proposition that governments will be able to choose productive value-adding forms of expenditure is an illusion. Your plan is to redirect the source of expenditure to the people least capable to choosing where the most productive investments would be found.

I’m afraid your program would be part of the problem and in no way part of any solution. I fear that three quarters of a century after the publication of The General Theory, economics is now at such a low ebb that what you have written will look like perfect sense to all too many, even as every attempt in the past to do what you have suggested has made things worse than they already were.

In times gone by, before Keynes, economists talked about “effective demand”, that is, what was required to turn the desire for products into an ability to buy those products. Now it is aggregate demand – the total level of demand – which has leached the original concept of any appreciation that for everyone to buy from each other – to raise aggregate demand as you might put it – they must first produce what others wish to buy. A freshly dug hole that is immediately refilled will not do even if money is paid for the work. If that is not obvious, then common sense has gone from the world.

But I say again. A short post cannot state everything that needs to be said. For a more complete explanation of these issues and what needs to be done, you must turn to the second edition of my Free Market Economics. It’s still not too late, but it is getting later all the time.

Kind regards

Steve Kates

——

Louis-Philippe’s Reply to Steve’s First Letter – published on 20th November 2014. Steve’s letter isbelow.

Dear Steven,

Thank you for your letter, which I was happy to read. I must confess, however, that we seem to have very different memories of this crisis (a word, by the way, that never appears in your letter) and an extremely different interpretation of the history of macroeconomics. I also don’t quite understand your passion against anything Keynesian. My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction. For that, he is remembered as one of the greatest thinkers. By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates. As you say, ‘you be the judge’.

You also suggest that Keynesians were wrong in their predictions of the duration of the crisis and you are undoubtedly right about Akerlof. But many other Keynesians were also predicting a long and worrisome recovery. And may I add, virtually no one in the mainstream of the profession, including Austrians, Libertarians and neoclassical economists, predicted this crisis. They were too busy with their badly-designed models to pay any attention to the real world. So, yes, I point a finger to neoclassical economists who believe in the Efficient Market Hypothesis which even denies such a crisis can occur. For that reason, they could not even see the crisis until it was right under their noses. Funny enough, at conferences a few years after the crisis began, those same economists were back to business as usual as if the crisis never happened. Surely, you are not asking me to have faith in the same theories that directly contributed to the greatest crisis in over 75 years.

As a “post”-Keynesian (not to be confused with ’Keynesian’ new, neo or other), I too predicted at a talk I gave at UNAM in Mexico in 2009 that this was going to be a long, dragged-out crisis, and even stated at the time that it was going to take at least a decade to recover. Many of my colleagues on the left made the same arguments. And, here we are seven years later. But now, I think I may have been wrong: I think it will take much longer.

But the reasons I gave then are even truer today: while governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures. You say, “we had the stimulus” but forget to mention that the stimulus policies were completely reversed a mere year after they were introduced. And make no mistake: that stimulus was working. We were well on our way to recovery until governments got spooked by those who were warning against high deficits and debt levels, and who bought into the fear-mongering propagated by the right that governments were going to go bankrupt if they spent beyond their means. Well, we know what happened, don’t we?

First, the embarrassing gaffe (to put it mildly) by Carmen Reinhart and Kenneth Rogoff, whose paper, ”Growth in a time of Debt”, was widely cited as empirical proof that too much debt can harm growth. Well they were quickly defrocked and their research exposed for what it truly was by an honest doctoral student from University of Massachusetts, Amherst, Thomas Herndon, who took the time to properly dot the i’s and cross the t’s. So that myth was clearly debunked. In fact, UNCTAD just released a new report indicating that among the top 7 countries with the worse austerity measures are Italy, Spain, Portugal, Greece and Ireland – all countries facing a dire economic situation. You be the judge.

Second, we now know that any country with a sovereign currency can never go bankrupt since a sovereign central bank can always buy all the required government debt.. And financial markets and speculators know this. The proof is in the pudding: while the US, the UK and Japan’s debt levels were much higher than many other countries, their interest rates were much lower. Clearly, financial markets know exactly this to be the truth and did not turn away from the US when the debt levels were climbing.

The worst infliction we can impose on our economies is to leave them to the tyranny of the markets. We now know with conviction that markets are by their very nature unstable and prone to crises, and must be regulated. Unfettered markets only lead to recessions and crises at which time governments must swoop in and clean up the mess.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. When the private sector is not spending, governments have the moral responsibility to intervene and ensure the spending is sufficient to encourage investment. Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect! When you look at aggregate demand today, it is at best anemic. Consumers are saddled with debt, and private investment has flatlined; austerity measures are being imposed everywhere. There is no room for growth. That leaves only exports to ensure a recovery. But with Europe on the verge of deflation, the BRIC countries slowing down, the prospects for exports are dimming. So where will growth come from? I am afraid that without aggressive fiscal deficit spending, we are dooming future generations and ourselves to another decade or more of weak economic growth. This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

So what do we need to get the world economy back to prosperity? Here is my four-prong solution:

First, we must replace private debt with public debt. This can only occur with a well coordinated fiscal stimulus among the leading economies. Here in Canada, our infrastructure is crumbling and in desperate need of massive public investment. I can think of a number of places that need investment: our health care system, our education, our national parks, our roads and bridges, and why not create national day care to help struggling families. In the US and elsewhere around the world, there are plenty of examples of much needed infrastructure spending and public investment projects. If there is ever a good time to borrow, now is the time as interest rates are at historically-low levels. Governments engaging in austerity should be held criminally negligent for their actions.

Second, we must put job creation above all other goals. Work offers dignity, which every person deserves. This requires governments to adopt a policy of full employment. This would require as well a prolonged period of low interest rates, with an injection of fiscal cash. I am always in disbelief when I witness the cavalier-indifference policy makers have towards the unemployed. This must end.

Third, we must deal head on with the problem of income inequality, which is at the very core of the crisis in aggregate demand. Interestingly enough, income inequality was as pronounced right before the crash of 1929 as it was right before the crisis began in 2007. This leads me to suggest that income inequality is one of the causes of the financial and economic crisis. If governments do not address this problem, we are doomed to repeat the problems of 2007 before long. For starters, we need to have a higher marginal tax rate on the rich, a high wealth tax, an important increase in the minimum wage; we must also at all cost reign in corporate bonuses and inflated CEO paychecks, eliminate practices such as buy backs, and raise the corporate tax.

Fourth, with respect to Europe, well that’s a mess of a different colour. Yes, austerity has veered its ugly head there as well, but they also have to deal with the shackles of a common currency. They must either adopt the proper federal institutions to deal with the problems facing the Southern countries, or get rid of the Euro all together. This will undoubtedly create some short-term angst, but the consequences of the status quo are a few decades of deflation. The Euro was an ill-planned policy: you cannot have a monetary union without a political union.

So I end here by staying that had we had more Keynesian aggregate demand policies, we would probably not be in this mess today, which is entirely the result of anti-Keynesian, short-sighted policies designed to benefit the very few rather than the masses.

So my dear Steven, we disagree on many issues. I look forward to your reply.

Steve Kates’ First Letter, which began this debate – published on 13th November 2014

Dear Louis-Philippe

There are about as many versions of Keynesian theory as there are Keynesians but all versions have two things in common. The first is that economies are driven by aggregate demand. The second is that an economy’s rate of growth and level of employment can be increased by increasing aggregate demand, either through higher public spending or lowering rates of interest. Both are wrong and the destructive consequences of these beliefs are everywhere to be seen.

The following was written by two winners of the Nobel Prize in economics just as the fiscal stimulus was being introduced.

In the middle of the Great Depression John Maynard Keynes published The General Theory of Employment, Interest and Money. In this 1936 masterwork, Keynes described how creditworthy governments like those of the United States and Great Britain could borrow and spend, and thus put the unemployed back to work. (Akerlof and Shiller, 2009: 2)

This is what I wrote at exactly the same time.

What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome. (Kates 2009)

You be the judge. Who was right? We had the stimulus and the unemployed have not been put back to work. We are instead in the sixth year of recessionary conditions which have indeed been deep, prolonged and which will still take years to overcome.

In the 1990s, Japan, at the time the most dynamic and amongst the fastest growing economies in the world, attempted the same kind of Keynesian stimulus. Its economy has remained comatose ever since.

And then, of course, there was the Great Stagflation of the 1970s brought on by the direct application of Keynesian theory to the problems of the time.

You would think after such consistent failure people would begin to understand that the problem is Keynesian theory, the common factor in each case. But so powerful has been the grip of the theory of aggregate demand that in spite of everything, the theory has virtually never been questioned.

If anyone knows anything about what Keynes wrote, it is that recessions are caused by too much saving. Public spending is therefore needed to soak up those savings, which businesses either cannot borrow because expected returns are too low or won’t borrow because interest rates have not fallen far enough. Here was Keynes’s advice on the kind of response that was therefore needed:

If the Treasury were to fill old bottles with banknotes, bury them . . . and leave it to private enterprise . . . to dig the notes up again . . . there need be no more unemployment. . . . It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing. (Keynes 1936: 128-129 and quoted with approval exactly as shown above in Temin and Vines 2014: 50)

This has been the essence of Keynesian theory from that day to this.

There is unemployment because the community is saving too much. Something must be done to put those savings to work. For various reasons, the private sector cannot be depended on to use those savings and interest rates cannot be lowered far enough. Therefore, public expenditure to soak up these savings must be increased and it is irrelevant whether such expenditure is in itself value adding. Even if a government increases expenditure on projects that are purely wasteful, this spending will increase the total level of aggregate demand. The increase in aggregate demand will then lead to an increase in national wealth and a fall in unemployment.

The specific point made by Keynesian economists is that spending on anything will restore an economy to full employment and raise living standards.

A century ago it was obvious to every economist alive why a stimulus of this kind could not work. Today the problems with such an approach are invisible and apparently incomprehensible.

Certainly a government can itself employ, or can buy from others causing those others to employ. And those additional employees can use their incomes to buy things from others still. And so, for a brief period of time, we can say there has been an increase in employment relative to how many might otherwise have been employed.

But unless whatever has been produced is value adding, as time goes by these additional employees merely drain away the productive capacity of the economy. Savings are indeed absorbed but the value left behind is lower than the value used up during production. The economy not only remains stagnant, it winds even further down as its resource base is diverted into wasteful forms of expenditure.

Moreover, the resource base of the economy is not just misdirected into the particular goods and services sought by governments, but the inputs, whose production has also been encouraged by the “stimulus”, become a further distortion of what was already a grossly misdirected structure of production.

The structure of the economy has thus become even more misshapen than it had been when the stimulus began and the problem cannot be cured until the non-value adding components of the stimulus are wound back. You can call the process “austerity” if you like. But the fact is that there can be no solution to the problems the stimulus has caused until the various non-value-adding projects the government has introduced are withdrawn.

The adjustment process is inescapably painful, far more drawn out than recovery from the original recession would have been, but there is no alternative if an economy is ever to regain its strength. But because they think in terms of aggregate demand, no Keynesian ever understands what needs to be done.

Let me approach this in a different way. This is the fundamental equation of Keynesian economics (leaving aside foreign trade):

Y = C + I + G

Aggregate demand (Y) is the amount spent by consumers on consumer goods (C) plus the amount spent by businesses on investment (I) plus total spending by governments (G). The underlying presumption is that the higher the level of Y, the higher the level of output and employment.

In a recession business investment goes down, and as Y goes down, employees lose their jobs. To lift Y back up and therefore raise employment, the policy recommended by Keynesians is to raise the level of government spending on absolutely anything at all.

What you then have is less investment by business and more spending directed by governments. The proportion of expenditure on productive forms of output has been reduced while spending on less productive and often totally unproductive forms of output has increased.

No one wants recessions and the unemployment recessions bring. But a Keynesian response that attempts to lift aggregate demand without first increasing value-adding supply can never succeed. There is no mechanism that can lead from higher levels of wasteful expenditure to higher living standards and more employment.

That so many seem unable to learn from experience, or any longer understand the reasons why wasteful spending can never be a solution to recessions and unemployment, is the most astonishing part about having watched events unfold since the GFC.

Obviously, none of this can be properly explained in a brief note of a thousand words. If you are interested in understanding not only why Keynesian economics provides no solutions to our economic problems, but also what should be done instead, read the second edition of my Free Market Economics: an Introduction for the General Reader. There is literally nothing else like it anywhere.

Best wishes,

Steve

–

Bibliography

Akerlof, George and Shiller, Robert. 2009. Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton, NJ: Princeton University Press.

]]>https://elgar.blog/2014/11/27/elgar-debates-how-to-promote-a-global-economic-recovery-markets-have-been-the-single-most-liberating-institution-in-possibly-the-entire-history-of-the-human-race/feed/01200px-NY_stock_exchange_traders_floor_LC-U9-10548-6katyroperjean-leon-gerome-a-collaboration-corneille-and-moliereSamuel_Johnson_by_Joshua_Reynolds_2GrantKeynesElgar Debates: How to Promote a Global Economic Recovery? “The worst infliction we can impose on our economies is to leave them to the tyranny of the markets”https://elgar.blog/2014/11/20/elgar-debates-how-to-promote-a-global-economic-recovery-the-worst-infliction-we-can-impose-on-our-economies-is-to-leave-them-to-the-tyranny-of-the-markets/
https://elgar.blog/2014/11/20/elgar-debates-how-to-promote-a-global-economic-recovery-the-worst-infliction-we-can-impose-on-our-economies-is-to-leave-them-to-the-tyranny-of-the-markets/#commentsThu, 20 Nov 2014 08:30:11 +0000http://elgarblog.wordpress.com/?p=4261

What are the best economic policies to promote global recovery?In the first letter of our Elgar Debates series, Steve Kates presented the Free Market view of the current economic crisis. In this second letter Louis-Philippe Rochon gives his reply, setting out what he sees as the problems with reliance on the market and suggesting four practical steps to promote economic recovery.Dear Steven,

Thank you for your letter, which I was happy to read. I must confess, however, that we seem to have very different memories of this crisis (a word, by the way, that never appears in your letter) and an extremely different interpretation of the history of macroeconomics. I also don’t quite understand your passion against anything Keynesian. My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction. For that, he is remembered as one of the greatest thinkers. By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates. As you say, ‘you be the judge’.

You also suggest that Keynesians were wrong in their predictions of the duration of the crisis and you are undoubtedly right about Akerlof. But many other Keynesians were also predicting a long and worrisome recovery. And may I add, virtually no one in the mainstream of the profession, including Austrians, Libertarians and neoclassical economists, predicted this crisis. They were too busy with their badly-designed models to pay any attention to the real world. So, yes, I point a finger to neoclassical economists who believe in the Efficient Market Hypothesis which even denies such a crisis can occur. For that reason, they could not even see the crisis until it was right under their noses. Funny enough, at conferences a few years after the crisis began, those same economists were back to business as usual as if the crisis never happened. Surely, you are not asking me to have faith in the same theories that directly contributed to the greatest crisis in over 75 years.

As a “post”-Keynesian (not to be confused with ’Keynesian’ new, neo or other), I too predicted at a talk I gave at UNAM in Mexico in 2009 that this was going to be a long, dragged-out crisis, and even stated at the time that it was going to take at least a decade to recover. Many of my colleagues on the left made the same arguments. And, here we are seven years later. But now, I think I may have been wrong: I think it will take much longer.

But the reasons I gave then are even truer today: while governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures. You say, “we had the stimulus” but forget to mention that the stimulus policies were completely reversed a mere year after they were introduced. And make no mistake: that stimulus was working. We were well on our way to recovery until governments got spooked by those who were warning against high deficits and debt levels, and who bought into the fear-mongering propagated by the right that governments were going to go bankrupt if they spent beyond their means. Well, we know what happened, don’t we?

First, the embarrassing gaffe (to put it mildly) by Carmen Reinhart and Kenneth Rogoff, whose paper, ”Growth in a time of Debt”, was widely cited as empirical proof that too much debt can harm growth. Well they were quickly defrocked and their research exposed for what it truly was by an honest doctoral student from University of Massachusetts, Amherst, Thomas Herndon, who took the time to properly dot the i’s and cross the t’s. So that myth was clearly debunked. In fact, UNCTAD just released a new report indicating that among the top 7 countries with the worse austerity measures are Italy, Spain, Portugal, Greece and Ireland – all countries facing a dire economic situation. You be the judge.

Second, we now know that any country with a sovereign currency can never go bankrupt since a sovereign central bank can always buy all the required government debt.. And financial markets and speculators know this. The proof is in the pudding: while the US, the UK and Japan’s debt levels were much higher than many other countries, their interest rates were much lower. Clearly, financial markets know exactly this to be the truth and did not turn away from the US when the debt levels were climbing.

The worst infliction we can impose on our economies is to leave them to the tyranny of the markets. We now know with conviction that markets are by their very nature unstable and prone to crises, and must be regulated. Unfettered markets only lead to recessions and crises at which time governments must swoop in and clean up the mess.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. When the private sector is not spending, governments have the moral responsibility to intervene and ensure the spending is sufficient to encourage investment. Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect! When you look at aggregate demand today, it is at best anemic. Consumers are saddled with debt, and private investment has flatlined; austerity measures are being imposed everywhere. There is no room for growth. That leaves only exports to ensure a recovery. But with Europe on the verge of deflation, the BRIC countries slowing down, the prospects for exports are dimming. So where will growth come from? I am afraid that without aggressive fiscal deficit spending, we are dooming future generations and ourselves to another decade or more of weak economic growth. This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

Louis-Philippe Rochon is a Founding Co-Editor of the Review Of Keynesian Economics

So what do we need to get the world economy back to prosperity? Here is my four-prong solution:

First, we must replace private debt with public debt. This can only occur with a well coordinated fiscal stimulus among the leading economies. Here in Canada, our infrastructure is crumbling and in desperate need of massive public investment. I can think of a number of places that need investment: our health care system, our education, our national parks, our roads and bridges, and why not create national day care to help struggling families. In the US and elsewhere around the world, there are plenty of examples of much needed infrastructure spending and public investment projects. If there is ever a good time to borrow, now is the time as interest rates are at historically-low levels. Governments engaging in austerity should be held criminally negligent for their actions.

Second, we must put job creation above all other goals. Work offers dignity, which every person deserves. This requires governments to adopt a policy of full employment. This would require as well a prolonged period of low interest rates, with an injection of fiscal cash. I am always in disbelief when I witness the cavalier-indifference policy makers have towards the unemployed. This must end.

Third, we must deal head on with the problem of income inequality, which is at the very core of the crisis in aggregate demand. Interestingly enough, income inequality was as pronounced right before the crash of 1929 as it was right before the crisis began in 2007. This leads me to suggest that income inequality is one of the causes of the financial and economic crisis. If governments do not address this problem, we are doomed to repeat the problems of 2007 before long. For starters, we need to have a higher marginal tax rate on the rich, a high wealth tax, an important increase in the minimum wage; we must also at all cost reign in corporate bonuses and inflated CEO paychecks, eliminate practices such as buy backs, and raise the corporate tax.

Fourth, with respect to Europe, well that’s a mess of a different colour. Yes, austerity has veered its ugly head there as well, but they also have to deal with the shackles of a common currency. They must either adopt the proper federal institutions to deal with the problems facing the Southern countries, or get rid of the Euro all together. This will undoubtedly create some short-term angst, but the consequences of the status quo are a few decades of deflation. The Euro was an ill-planned policy: you cannot have a monetary union without a political union.

So I end here by staying that had we had more Keynesian aggregate demand policies, we would probably not be in this mess today, which is entirely the result of anti-Keynesian, short-sighted policies designed to benefit the very few rather than the masses.

So my dear Steven, we disagree on many issues. I look forward to your reply.

Steve Kates’ reply will be published next week. Read Steve’s first letter in this series here.

]]>https://elgar.blog/2014/11/20/elgar-debates-how-to-promote-a-global-economic-recovery-the-worst-infliction-we-can-impose-on-our-economies-is-to-leave-them-to-the-tyranny-of-the-markets/feed/2Unemployed_men_queued_outside_a_depression_soup_kitchen_opened_in_Chicago_by_Al_Capone,_02-1931_-_NARA_-_541927katyroperunemployed_men_queued_outside_a_depression_soup_kitchen_opened_in_chicago_by_al_capone"Samuel Johnson by Joshua Reynolds 2" by Joshua Reynolds - Originally in English Wikipedia, uploaded 21:07, 2005 June 14 by w:User:GeogreScanned from: Rogers, Pat (2001). The Oxford Illustrated History of English roke_cover-thumb